Commentary on Economics, Information and Human Action

The “utility death spiral”: The utility as a regulatory creation

Unless you follow the electricity industry you may not be aware of the past year’s discussion of the impending “utility death spiral”, ably summarized in this Clean Energy Group post:

There have been several reports out recently predicting that solar + storage systems will soon reach cost parity with grid-purchased electricity, thus presenting the first serious challenge to the centralized utility model. Customers, the theory goes, will soon be able to cut the cord that has bound them to traditional utilities, opting instead to self-generate using cheap PV, with batteries to regulate the intermittent output and carry them through cloudy spells. The plummeting cost of solar panels, plus the imminent increased production and decreased cost of electric vehicle batteries that can be used in stationary applications, have combined to create a technological perfect storm. As grid power costs rise and self-generation costs fall, a tipping point will arrive – within a decade, some analysts are predicting – at which time, it will become economically advantageous for millions of Americans to generate their own power. The “death spiral” for utilities occurs because the more people self-generate, the more utilities will be forced to seek rate increases on a shrinking rate base… thus driving even more customers off the grid.

The financial risks created by disruptive challenges include declining utility revenues, increasing costs, and lower profitability potential, particularly over the long term. As DER and DSM programs continue to capture “market share,” for example, utility revenues will be reduced. Adding the higher costs to integrate DER, increasing subsidies for DSM and direct metering of DER will result in the potential for a squeeze on profitability and, thus, credit metrics. While the regulatory process is expected to allow for recovery of lost revenues in future rate cases, tariff structures in most states call for non-DER customers to pay for (or absorb) lost revenues. As DER penetration increases, this is a cost recovery structure that will lead to political pressure to undo these cross subsidies and may result in utility stranded cost exposure.

I think the apocalyptic “death spiral” rhetoric is overblown and exaggerated, but this is a worthwhile, and perhaps overdue, conversation to have. As it has unfolded over the past year, though, I do think that some of the more essential questions on the topic are not being asked. Over the next few weeks I’m going to explore some of those questions, as I dive into a related new research project.

The theoretical argument for the possibility of death spiral is straightforward. The vertically-integrated, regulated distribution utility is a regulatory creation, intended to enable a financially sustainable business model for providing reliable basic electricity service to the largest possible number of customers for the least feasible cost, taking account of the economies of scale and scope resulting from the electro-mechanical generation and wires technologies implemented in the early 20th century. From a theoretical/benevolent social planner perspective, the objective is, given a market demand for a specific good/service, to minimize the total cost of providing that good/service subject to a zero economic profit constraint for the firm; this will lead to highest feasible output and total surplus combination (and lowest deadweight loss) consistent with the financial sustainability of the firm.

The regulatory mechanism for implementing this model to achieve this objective is to erect a legal entry barrier into the market for that specific good/service, and to assure the regulated monopolist cost recovery, including its opportunity cost of capital, otherwise known as rate-of-return regulation. In return, the regulated monopolist commits to serve all customers reliably through its vertically-integrated generation, transmission, distribution, and retail functions. The monopolist’s costs and opportunity cost of capital determine its revenue requirement, out of which we can derive flat, averaged retail prices that forecasts suggest will enable the monopolist to earn that amount of revenue.

That’s the regulatory model + business model that has existed with little substantive evolution since the early 20th century, and it did achieve the social policy objectives of the 20th century — widespread electrification and low, stable prices, which have enabled follow-on economic growth and well-distributed increased living standards. It’s a regulatory+business model, though, that is premised on a few things:

Defining a market by defining the characteristics of the product/service sold in that market, in this case electricity with a particular physical (volts, amps, hertz) definition and a particular reliability level (paraphrasing Fred Kahn …)

The economies of scale (those big central generators and big wires) and economies of scope (lower total cost when producing two or more products compared to producing those products separately) that exist due to large-scale electro-mechanical technologies

The architectural implications of connecting large-scale electro-mechanical technologies together in a network via a set of centralized control nodes — technology -> architecture -> market environment, and in this case large-scale electro-mechanical technologies -> distributed wires network with centralized control points rather than distributed control points throughout the network, including the edge of the network (paraphrasing Larry Lessig …)

The financial implications of having invested so many resources in long-lived physical assets to create that network and its control nodes — if demand is growing at a stable rate, and regulators can assure cost recovery, then the regulated monopolist can arrange financing for investments at attractive interest rates, as long as this arrangement is likely to be stable for the 30-to-40-year life of the assets

As long as those conditions are stable, regulatory cost recovery will sustain this business model. And that’s precisely the effect of smart grid technologies, distributed generation technologies, microgrid technologies — they violate one or more of those four premises, and can make it not just feasible, but actually beneficial for customers to change their behavior in ways that reduce the regulation-supported revenue of the regulated monopolist.

Digital technologies that enable greater consumer control and more choice of products and services break down the regulatory market boundaries that are required to regulate product quality. Generation innovations, from the combined-cycle gas turbine of the 1980s to small-scale Stirling engines, reduce the economies of scale that have driven the regulation of and investment in the industry for over a century. Wires networks with centralized control built to capitalize on those large-scale technologies may have less value in an environment with smaller-scale generation and digital, automated detection, response, and control. But those generation and wires assets are long-lived, and in a cost-recovery-based business model, have to be paid for even if they become the destruction in creative destruction. We saw that happen in the restructuring that occurred in the 1990s, with the liberalization of wholesale power markets and the unbundling of generation from the vertically-integrated monopolists in those states; part of the political bargain in restructuring was to compensate them for the “stranded costs” associated with having made those investments based on a regulatory commitment that they would receive cost recovery on them.

Thus the death spiral rhetoric, and the concern that the existing utility business model will not survive. But if my framing of the situation is accurate, then what we should be examining in more detail is the regulatory model, since the utility business model is itself a regulatory creation. This relationship between digital innovation (encompassing smart grid, distributed resources, and microgrids) and regulation is what I’m exploring. How should the regulatory model and the associated utility business model change in light of digital innovation?

7 thoughts on “The “utility death spiral”: The utility as a regulatory creation”

The “death spiral”, at least in Europe, is also accelerated by the large subsidies – particularly to renewable sources – that are incorporated in the power bill. By getting off the grid, a consumer does not only benefit from the potential cost-effectiveness of the technologies that already are, or that will soon become, available. She also skips the burden of subsidies that – just to provide you with an order of magnitude – in Italy amount at as much as 40-50 euro/MWh. The consequence is double-edged. On the one hand utilities have to rely upon a shrinking base of customers (and therefore they will serve a progressively decreasing demand), with the result that the existing generating capacity becomes more and more abundant and wholesale prices get subsequently lower and lower making it harder and harder for utilities to recover their fixed costs (in the medium to long run this will inevitably lead to power plant closures, consolidation, and perhaps more stranded costs, either explicitly or in the form of un-necessary capacity support schemes). On the other hand, the share of consumers that for some reason cannot switch to off-grid settings will have to bear the entire cost of subsidies and other sunk costs (eg the network costs). This is primarily a result of badly-designed policies, not the genuine consequence of the kind of technological evolution that you are describing.

I have no idea of how a way out might look like – a reasonable compromise is that of taxing the energy which is self-consumed within network configurations that remain connected to the existing power grid and that rely on it for some share of their need – in order to drive from there at least part of the resources that otherwise would have to be extracted from the remaining customer base. This is what countries like Germany and Italy are trying to do. But I suspect that this is only a short-term response, however necessary, and that – as with many other policy-induced problems – there will be a lot of pain among utilities as well as consumers before this is fixed.

I don’t believe that decentralized power generation and storage actually can compete economically with the traditional centralized transmission grid. Hence the business model/production strategy of the traditional utility is not an artifact of regulation–the reverse is true (under the background assumption that unregulated monopolies are not politically stable). The growth of solar and wind and negawatts depends entirely on the subsidy policies that favor these less-efficient methods and burden other grid users with both the cross-subsidy and the lost capacity-utilization efficiencies. If solar and wind owners were required to pay the freight for backup capacity and were denied the right to sell their unwanted excess power back to the grid at high prices, there would be no threat of a death spiral.

Gosh, they make it sound like “death spiral” is a bad thing. If it means that an unsustainable regulatory superstructure collapses, and is replaced by a diverse and competitive industry, then what’s not to like? Back in 1981 the Reagan transition team looked at repealing PURPA, but were persuaded that it at least had the virtue of creating an unregulated competitive fringe — the IPPs, who, over time, would erode the state-regulated monopolies. Death spiral was very much the policy goal.

I don’t think that centralized power production (except perhaps coal, another story) is going to disappear, however. We just need to realize that it cannot bear the weight of all the cross subsidies that it has been forced to undertake. Universal service was the original rationale for cross-subsidies, and for the regulatory barriers-to-entry that feed them. Once you have created the mechanism for cross-subsidies, however, how do you guard against the armies of rent-seekers that it will attract? See, for example, the fiasco that EPA’s Renewable Fuel Standard has become.

This has been, and will continue to be, a long-term process. Electric power is a heavily crenelated industry (see my comment here: http://www.libertylawsite.org/liberty-forum/the-new-cronyism-of-the-old-rent-seeking-state/ for what I mean by that). But the path forward is pretty clear. Embrace the competitive forces (from whatever source), fight the rent-seekers, trim the subsidies, keep an eye on reliability (and allow utilities to price it appropriately), and see what emerges.

Solar nuts tend to come up with fantasies like this. The fact is that putting up solar panels and buying batteries would be ungodly expensive even if the solar cells were free. Look, it cost me $15,000 to put on a new roof made out of asphalt shingles which are going to be cheaper than the cheapest solar panels.

Don’t forget wiring and electronics. I would guess that a whole house system with reasonable storage would run at least $40,000, probably more. Currently I buy about 2,000 KWh/mo for about $250. So I would have to run that rig for more than 13 years without additional cost to break even.

Batteries don’t last that long, and solar panels on the roof won’t last that long. It is a lead pipe loser.